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Thursday, September 20, 2012

The Potential GDP Perspective on Business Cycles

The Congressional Budget Office calculates "potential GDP," which is the amount that the economy would produce at full employment. During a recession, actual economic output is below potential GDP; during an extreme economic boom, like the dot-com boom of the late 1990s, the economy can for a time have output greater than potential GDP. Here's a graph showing potential GDP in blue and actual GDP in red, both in real dollars from 1960 up through the mid-2012, generated by the ever-useful FRED website of the Federal Reserve Bank of St. Louis.

The graph does usefully show the depth of the current recession, and other recessions, as well as how actual GDP climbs above potential GDP in the dot-com boom of the late 1990s, as well as during the guns-and-butter period of the late 1960s and the housing boom of the mid-2000s. But you do have to squint a bit to make it all out! And your eye can be fooled in thinking about the depth of recessions, because the graph shows the gaps in absolute levels, not in percentage terms. Thus, when GDP is much lower back in the 1960s, the absolute gap may appear small, but the percentage gap could be larger.

So here's a graph based on the same data that shows the percentage amount by which actual GDP was above or below potential GDP in the years from 1960 up through mid-2012.

A few themes jump out from looking at the data in this way:

1) If the Great Recession is measured according to how far the economy had fallen below potential GDP, it is actually quite similar to the effects of the double-dip recession in the early 1980s.

2) If the Great Recession is measured by the size of the drop, relative to potential GDP, it is about 9 percentage points of GDP (from an actual GDP 1 percent above potential GDP to an actual GDP that is 8 percent below potential GDP). The total size of this drop isn't all that different--although the timing is different--from the years around the double-dip recession of the 1980s, the years around the recession of 1973-75, and the recession of 1969-1970.

3) The recovery from the early 1980s recessions was V-shaped, while the recovery from the Great Recession is more gradual. But this change isn't new. The recoveries from all the recessions before the early 1980s were reasonably V-shapes, and the recoveries after the 1990-91 and 2001 recessions were more U-shaped, as well.

4) The most red-hot time for the U.S. economy in this data, in the sense that the economy was running unsustainably ahead of potential GDP for a time, was what is sometimes called the "guns-and-butter" period of the late 1960s an early 1970s, when the federal government spent on both social programs and the military at the same time. In the dot-com boom, the economy was also well above potential GDP. The U.S. economy was also unsustainably above potential GDP during the housing boom around 2005-6, but it wasn't as white-hot a period of economic boom as these others.